How Swaps Work and

Why Issuers Use Them

Introduction to Interest Rate Swaps
California Debt and Investment Advisory Commission
April 11, 2008
Swap Financial Group
Peter Shapiro
76 South Orange Avenue, Suite 6
South Orange, New Jersey 07079
973-378-5500

Agenda
z What

can swaps do for you as a

borrower?
z What risks do they pose?
z How can you maximize benefits and
minimize risks?

Swap Financial Group

What are swaps?

z
z
z

Swaps are an alternative way to access the

market for capital
Major borrowers evaluate the swap market
and the bond market side by side
Typical swap:

2 parties (counterparties)
Exchange different forms of interest rates
Defined period
Usually, one party pays fixed and the other pays
floating
Swap Financial Group

Why swap?
z Savings:

Provide substantially better

economic results than those available in
the conventional bond market
z Flexibility: Provide a solution to a
financial problem which is not available
in the conventional market
z Speed: Take advantage of market
opportunity swiftly
Swap Financial Group

Swap structure (to fixed)

Fixed Rate
Issuer

Swap Dealer
Floating Index

Bond Rate
(Floating)

Bond Holder

Issuer pays Swap Fixed

Rate minus the
Difference between the
two Floating Rates

Swap Financial Group

Tax-exempt bonds vs. swaps

5.50

5.50

5.00

5.05

4.50
4.44

4.00
3.85

3.75

3.50
3.31

3.90

Bond
Swap

3.45

3.00
2.50
10 Year

15 Year

20 Year

30 Year

Note: Swap rate includes 26 bps cost of annual floating bond costs. Prices are illustrative.
Swap Financial Group

Math: Swaps vs. Bonds

Bonds
9 Fixed coupon
9 + Amortized cost of
issuance
9= All-in cost

Swap
9 Floating bond rate
9 + Annual costs of
floaters (auction fees or
remarketing and
liquidity)
9 + Fixed swap rate
9 Floating swap rate
9=

All-in cost

Swap Financial Group

Plug in some numbers

Bonds
9 5.45% (fixed coupon)
9 + 0.05% (amortized cost
of issuance)
9= 5.50% (all-in cost)

Swap
9 VR% (floating bond
rate)
9 + 0.26% (annual floating
bond costs)
9 + 3.64% (fixed swap
rate)
9 VR (floating swap
rate)
9= 3.90% (all-in cost)

Swap Financial Group

Why does it work?

z

Counter-intuitive: Why should three steps (issue

floating, receive floating, pay fixed) be more
efficient than one (issue fixed)
Swaps allow you to unbundle and take
advantage of relative efficiencies of different
markets, and to decide to take certain risks (i.e.
greater or lesser amount of basis risk)
Market sensitive: It doesnt always work

Swap Financial Group

Inside the Swap Market

A huge, liquid market

160
140
120
100
Size in
Trillions of 80
Dollars
60

Swaps

40
20
Treasurys

Stocks

Swap Financial Group

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Swap market participants

Dealers
End Users
Arbitrageurs
& Speculators

Swap Financial Group

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Major governmental end-users

z

States: Alabama, Alaska, California, Colorado,

Connecticut, Florida, Georgia, Idaho, Illinois,
Louisiana, Maine, Massachusetts, Michigan,
Nevada, New Jersey, New York, North Carolina,
Ohio, Oregon, Pennsylvania, Texas, Utah,
Wisconsin
Cities and Counties: New York, Los Angeles,
Houston, Chicago, San Francisco, Atlanta,
Philadelphia, Miami-Dade, Baltimore, Cleveland,
Portland, New Orleans, Orlando, Fayetteville
Many California issuers
Swap Financial Group

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Role of the dealer

z
z
z

Unable to perfectly
match client trades
Must be market
maker
Credit intermediation
one end-user is not
exposed to anothers
credit
Processing,
bookkeeping,
payment calculation

Swap Financial Group

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How swap dealers make money

z
z

z
z
z

Swap dealers dont make bets - internal rules require

traders to hedge most positions
Dealers make money by earning a spread between the
price charged to the client and cost at which they hedge
(the bid-offered spread)
Part of SFGs job is to demonstrate the level of dealer
profit by establishing the dealers hedge price
Establishing hedge prices is easiest in the most liquid
markets (LIBOR), but is attainable in the BMA market
We believe in a fair, disclosed profit margin, agreed to
by the client, in all negotiated deals
Swap Financial Group

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Role of arbitrageur
z
z
z
z

Speculation pure
profit
Looks for
inefficiencies
Biggest risk taker
Very picky on
timing

Swap Financial Group

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Swap scandals
z

z
z
z

West Basin Municipal Water District,

California Board members indicted, suit
against financial advisor
Jefferson County, Alabama The Banks
that Fleeced Alabama
Biola University off-market swap pricing
Philadelphia City treasurer and lead
banker go to jail
Swap Financial Group

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Swap indexes
z
z

The floating side of a swap is usually an index

Two important floating indexes are:
LIBOR (London Interbank Offered Rate):
Dominant index for taxable floating rates
SIFMA (Securities Industry and Financial Markets
Association Municipal Swap Index, was BMA):
Dominant index for tax-exempt floating rates
Many tax-exempt issuers use a percentage of LIBOR
(between 64% and 70%) as the floating index, for
greater liquidity and savings
Swap Financial Group

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How you get out of a swap

z
z
z

The issuer can get out of a swap, or terminate,

at any time.
The swap provider generally cannot.
There is no prepayment penalty for
terminating early instead there is a gain or
loss, called a termination payment.
The termination payment is based on:
Interest rates at time of termination
Remaining years to scheduled maturity
Notional principal amount
Swap Financial Group

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How termination works

z

z
z

Compare original contract swap rate with

current market rate for a swap ending on the
same date
Multiply rate difference times dollar size and
years remaining, present valued
Example: Original rate (5.50%); current rate
(4.50%); difference (1.00%) times size ($10 mm
= $100,000) times years remaining (10 years =
$1 mm), present valued (at 4.50% = $770,000)
Swap Financial Group

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Measuring Termination Exposure

Assume Issuer has entered into a $100 million 30-year swap paying 4.50% and receiving
the BMA Municipal Swap Index. The table shows the Replacement Value of the swap at
future points in time, assuming 200 and 100 basis point increases in rates, and no
principal amortization.

Remaining Life of Swap

10 Years
15 Years
200
basis
points
100
basis
points

20 Years

$11,975,000

$14,574,000

$16,994,000

$6,344,000

$7,874,000

$9,432,000

Swap Financial Group

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Swap Risks

Counterparty risk
z
z
z
z

Bonds: Investors take risk to issuer, not vice-versa

Swaps: Both sides are at risk for entire term
The #1 risk on long contracts
Risk Measurement: Replacement cost, not notional
principal amount

Swap Financial Group

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Counterparty risk mitigation

Start with a quality counterparty

1.

Strong natural rating

Synthetic triple-As

Downgrade collateralization provisions

2.

3.

amount equal to the Replacement Value

frequent mark-to-market of both collateral value
and swap replacement value

Early termination on further downgrade

Swap Financial Group

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Swap dealer universe

z

Goldman Sachs
GS Capital Markets (Aa3/AA-)
GS Mitsui Marine Derivative Products
(Aaa/AAA)
Morgan Stanley
MS Capital Services (Aa3/AA-)
MS Derivative Products (Aaa/AAAt)
Merrill Lynch
ML Capital Services (A1/A+)
ML Derivative Products (Aaa/AAA)
Lehman Brothers
LB Special Financing (A1/A+)
LB Derivative Products (Aaa/AAAt)
Bear Stearns (now guaranteed by JPMorgan)
BS Capital Markets (Aa2/AA-)
BS Financial Products (Aaa/AAA)

z
z

Citigroup
Citibank N.A. (Aa1/AA)
Citigroup Financial Products
(Aa2/AA-)
Salomon Swapco (Aaa/AAAt)
JPMorgan
JPMorgan Chase Bank (Aaa/AA)
UBS
UBS AG (Aa1/AA-)
A few others:
Bank of America N.A. (Aaa/AA+)
Royal Bank of Canada (Aaa/AA-)
Bank of New York (Aaa/AA-)

Swap Financial Group

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Termination Risk
z Termination

Risk is the risk of an

involuntary, unscheduled termination of
a swap prior to its planned maturity.
z Involuntary termination may occur due
principally to these factors:
Swap dealer downgrade (below single-A)
Issuer downgrade (below triple-B)
Events of default
Swap Financial Group

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Termination risk mitigation

z
z

Maintain a low, very remote termination

trigger for your own credit
Use of swap insurance requires a downgrade of
both your credit and swap insurers credit to
trigger termination
If dealer downgrade triggers termination,
termination is on your side of bid-offered
spread (you can replace dealer with no out-ofpocket cost)
Swap Financial Group

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Basis Risk
z

Basis Risk is the risk that the floating rate you

receive on your swaps doesnt offset the
floating rate you pay on your bonds

Swap Financial Group

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Review of swap structure

Fixed Rate
Swap
Dealer

Issuer
Floating Index
Bond Rate
(Floating)

Basis Risk comes from

the difference between
the two Floating Rates
Bond Holder
Swap Financial Group

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SIFMA basis risk

z
z
z
z

SIFMA Basis risk: SIFMA (floating rate on

swap) fails to cover the floating rate on bonds
SIFMA normally closely corresponds to actual
tax-exempt floaters
Credit events, etc., may cause your bonds to
trade worse
2008 Key Issue: Auction Rate meltdown

Swap Financial Group

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LIBOR basis risk

z
z
z
z
z
z

Tax-exempt floaters normally trade at a percentage of

the taxable LIBOR index (i.e. 67%)
What would happen if munis lost preferential tax
treatment?
Bondholder bears risk with fixed-rate bonds
Issuer bears risk with unhedged floating rate bonds
and % of LIBOR swaps
Worst case: Muni floaters trade flat to LIBOR
What happens with % of LIBOR swap: Issuer pays
bondholders LIBOR on floaters, receives 67% of
LIBOR on swap; net loss of 33% of LIBOR
Swap Financial Group

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Tax risk scenario

Current Tax Structure

Radical Tax Change

4% Fixed

4% Fixed

Issuer

67% LIBOR

Swap

Issuer

Bond Rate =
66% LIBOR

Bonds

67% LIBOR

Swap

Bond Rate =
82% LIBOR

Net funding cost =

4% minus 1% of LIBOR;
LIBOR today is 2.50%, so
1% of LIBOR 2.5 bps;
Bottom line cost 3.98%

Bonds

Swap Financial Group

Net funding cost =

4% plus 15% of LIBOR;
LIBOR goes up to 8.00%, so
15% of LIBOR = 120 bps;
Bottom line cost 5.20%
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Tax risk events

Small effect: Reduction in federal rates
2. Larger effect: Exemption of all investment
income corporate bond interest, dividends,
capital gains from income tax
3. Largest effect: Taxation of munis under a
Flat Tax, with no grandfather clause
Key Questions: How real is the risk? Does the
benefit more than compensate for the risk?
1.

Swap Financial Group

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Assessing tax risk

z

z
z

The tax risk in a tax-risk swap is no different

from the tax risk you take on today with
floating tax-exempt bonds.
If munis lose their tax-exemption, floating rates
will rise relative to taxable rates.
Tax risk swaps allow you to unbundle tax risk
from floating rate risk -- you can hedge against
rising floating rates but retain the risk (and
significant rate benefits) of drastic changes in
the tax code
Swap Financial Group

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Many markets reward LIBOR users

6.00%

5.50%

5.50%
5.00%

3.00%

67% LIBOR

3.50%

3.90%

BMA

4.00%

Conventional

4.50%

4.40%

2.50%

Swap Financial Group

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Getting a Fair Price

How swaps are priced

z

z
z
z

All swaps can be modeled to determine the

mid-market level (halfway between the bid
and the offered)
Establishing mid-market can be done by most
swap professionals for simple structures
Complex structures require heavier systems,
better data flow, and more experience
Once mid-market is established, the key
question is the dealers spread
Swap Financial Group

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Dealers spread
z
z

Cost of hedging: Usually 1 to 3 bps

Credit reserve:
Excellent credits less than 1 bp
Middle credits (AA- to BBB+) 2 to 5 bps
Weak credits (BBB and below) 6 to 15 bps

Profit: Wide variation 3 to 20 bps

All elements should be fair and disclosed to you

Swap Financial Group

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